What really caused the Great Recession? Keynesians vs. “Austrians”

For all of the arguing about economics that has occurred the past couple of years, there are a couple points of view that emerge about the financial crisis that we went through in 2008, and about what we should do now. This is a rough conception that I’ve arrived at through countless financial articles/books, so there is obviously some disagreement within these two camps. The first is de facto government policy, while the second is an alternative economic view I would like to explore (please note these are both SIMPLIFIED explanations).

Shit hit the fan in 2008 (click picture for link to a good article)

The Orthodox Keynesian View

Paul Krugman is a well-known Keynesian economist who is writing the hell out of this recession. In fact, reading all of his articles the past couple years is an excellent layman’s introduction to the economic thought that seems to be driving the government’s response to this crisis (albeit to a lesser degree than the extremes Krugman prefers).

Causes

In this worldview, the primary cause of the financial crisis was a failure of government regulation. In fact, poor government regulation is so important in this conception that any other factor is really a minor one (also note the drop-off in demand for housing). The financial world is self-evidently full of hucksters and frauds, who invented new financial products to make an end-run around decades of government regulation. Some of these products were astoundingly stupid, and blew up in our faces.

In this viewpoint, the free market is regarded with suspicion at best. Krugman perhaps says it most succinctly in a 2009 article: “There’s a lot to be said about the financial disaster of the last two years, but the short version is simple: politicians in the thrall of Reaganite ideology dismantled the New Deal regulations that had prevented banking crises for half a century, believing that financial markets could take care of themselves. The effect was to make the financial system vulnerable to a 1930s-style crisis — and the crisis came.”

Solutions

Thus, we have something like the financial reform that is being pushed through Congress right now. The idea is to create a better regulated financial system so that future crises are averted. According to many Democratic politicians, if we can construct a regulatory system with enough checks to prevent bad derivatives and outright fraud in the financial sector, then we can avoid a crisis like the one in 2008.

Another point is that once a crisis is created, the government must act aggressively to prevent an economic collapse. Weak financial institutions need massive cash infusions to prevent systemic failure and depression. Government spending must be increased to make up for reduced private activity. Theoretically, the increased government spending should be removed once the economy recovers (though in practice, government spending is almost NEVER cut once implemented). In concrete terms we saw the TARP bailouts and the $800 billion economic stimulus. The TARP plan did prevent a financial meltdown, and the stimulus certainly did save a certain, hard-to-define number of jobs.

The overall argument, from this perspective, is roughly as follows: Without aggressive government action in 2008-2009, we would have faced a financial meltdown and a depression. Therefore, we had no choice but to bailout the financial system and flood the financial system with money.

An Alternative (“Austrian”) View

For lack of a better word, I will call the opposing viewpoint the “Austrian” view (most adherents are not strict Austrian economists, but there is a lot of influence from this quarter). Here is a good summary (written by Michael Pinto). In this view, no amount of stimulus or regulation can work, given the monstrous level of American indebtedness. When government and household debt are as high as they are now (nearly 100% of annual GDP), an economic collapse is necessary and impossible to avoid.

Causes

This view doesn’t discount the greed of mortgage brokers and financiers, and in fact it assumes their greed in spades. In this view, the financial world took complete advantage of the government to pursue an aggressive investment strategy, because key players knew one paramount fact: If they guessed right, they would make massive sums of money. If they guessed wrong, Uncle Sam would make good to them.

In this viewpoint, the implied government intervention (inevitable under Keynesian economics) guaranteed that a financial crisis would emerge. In fact, many of the biggest banks are profiting ENORMOUSLY from TARP, as it is basically policy now to give them these profits (via a 0.5% interest rate) while they nurse their balance sheets back into being. This can hardly serve as an effective deterrent to future risk-taking.

Additionally, this viewpoint blames the Federal Reserve heavily for the housing boom. The idea is (regardless of what regulation was in place) there would inevitably be an asset bubble of some kind, given the excessively low interest rates that predominated after the 2002 recession. To go even further, just as our bad response to the 2002 recession (excessive liquidity) sowed the seeds of an even bigger recession in 2008, so too will our bad response now create an even bigger problem in next few years.

Solutions

The solution to the crises in this view of the economy is to allow a debt deleveraging to occur. In the short-term, there will be deflation, asset prices will collapse, and we are likely to suffer a depression (the classic Keynesian nightmare). This is the only due course we can take now, given the cumulative results of our debt leveraging from c.1970-2005. This doesn’t deny that Obama’s stimulus may well have saved 1.5 million or even 2 million or 3 million jobs in the short-term. That’s not the point. The point is that such policies only weaken our economy further in the long-term and make future crises inevitable.

Indeed, above all, what we should avoid is anything that prolongs our economic reckoning to another day in the future. Things like the TARP bailout that are easy short-term solutions will only create bigger problems down the road. The “Austrian” would not try to re-inflate the housing market like the Keynesians did (with mortgage credits, 0% interest rates from the Fed, and FHA purchasing programs). By saving the banks and the housing speculators, we have embedded an economic cancer into the core of our system. This time bomb will inevitably explode and cause even more damage in the future.

Finally, this viewpoint looks down on the Dodd reforms as inherently ineffective. As long as it is government policy to re-inflate asset prices even further, financial regulation is an irrelevant point. Financiers will simply find new loopholes to exploit and it will be business as usual.

The overall argument, from this perspective, is roughly as follows: By further inflating an unstable economic arrangement, these policies guarantee that we’ll face a more serious depression at some point in the future than we would have faced in 2008-2009 by letting things run their course.

My own thoughts

I disagree with the Keynesian solution to this recession. It would have taken a LOT of guts, but Bush/Obama should not have proceeded with the bailout as they did. There are two main factors to their decision to do so. One is of course the advice of mainstream economics. Additionally, there are the massive financial industry contributions to both Bush and Obama that surely distorted their thinking in an unwelcome manner.

I have a very strong respect for theorists such as Frederic Bastiat and Friedrich Hayek. As someone who is 24 years old, I’m worried and think anyone my age should be worried about what is happening right now. This isn’t a case of “our children and grandchildren” will pay. This is a case of “we” will pay, and I don’t like the thought that me and people my age will be the ones stuck on the shit end of the stick when the 20th century debt boom implodes in the future. We may have bought ourselves some time with TARP and .5% federal interest rates, but these solutions will only magnify the pain we feel later.

On the question of financial reform, I do support basic rules regulating investment houses. What I question is whether our politicians are looking at the right cause of the financial crisis with their reform attempts. I also question whether the new system they create will make any difference.

Naturally, I allow that the summary above is greatly over-simplified and I would be willing to go into more details if anyone has questions/critiques.